A Cross-Sectional Analysis of the Excess Comovement of Stock Returns
Executive Summary — This paper develops cross-sectional predictions from a model in which the excess comovement of stock returns comes from correlated demand shocks. The model is tested on 298 Nikkei index stocks and 1,458 non-index stocks for the years 1993 through 2003. The study finds that controlling for index membership, index overweighting is a significant determinant of the comovement of returns with index returns. Key concepts include:
- Correlated investor demand for securities causes periodic and widespread mispricing.
- Members of arbitrarily weighted stock indexes, oftentimes "liquid" securities, are subject to frequent mispricing.
In the presence of limits to arbitrage, cross-sectional variation in periodic investor demand should be related to the degree of comovement of returns. I exploit the unusual weighting system of the Nikkei 225 index in Japan to identify cross-sectional variation in periodic demand for index stocks. Relative to their weights in a value weighted index, some stocks in the Nikkei are overweighted by a factor of ten or more. Using overweighting as an instrument for the proportionality between demand shocks for index stocks, I find a strong positive relation between overweighting and the comovement of a stock with other stocks in the index, and a negative relationship between index overweighting and comovement with stocks outside of the index. Put simply, overweighted stocks have high betas. The results suggest that excess comovement of stock returns is a consequence of an institutionalized commonality in trading behavior, rather than inefficiencies related to the speed at which index stocks incorporate economy-wide information.